A mutual fund is a pooled investment managed by an investment company. A money market fund is a special type of mutual fund that is limited by law to only invest in low-risk, short-term securities of U.S. corporations, federally-insured short-term certificates of deposit or short-term investment instruments issued by state, local or federal governments and their agencies. A money market fund is an investment security and selling shares of a money market fund may have tax consequences.
Money Market Funds
A money market fund is a special type of mutual fund, and should not be confused with a money market account offered by a bank, credit union or other type of depository financial institution. Unlike money market accounts offered by banks, money market funds are not insured by the Federal Deposit Insurance Corporation or any other federal agency, even though some or all of the investments held in the fund's portfolio may be so insured. Money market funds are low-risk investments, but they are still investment securities. It is possible to lose some of your investment in a money market fund.
Net Asset Value
The price of a share of a mutual fund is based on its net asset value. This value is determined by adding the current market prices of all of the fund's investments, subtracting any expenses and dividing the result by the total number of mutual fund shares. The net asset value of stock and bond mutual funds tends to fluctuate based on the market value of the investments in the fund's portfolio. Fund managers of money market funds attempt to maintain their net asset value at $1 per share. Any fluctuation in the market price of the fund's portfolio is reflected in the yield, rather than the net asset value. If the investments in the fund's portfolio perform poorly, it is possible that the fund's net asset value may drop below $1 per share.
There are two primary types of income that may be generated inside a money market fund and which may be passed on to the fund's shareholders. The fund may earn interest income paid by the securities held in the fund's portfolio. The interest on these securities may or may not be taxable at the local, state or federal level, depending on the type of security that pays the interest. The fund may also earn income through capital gains on the sale or redemption of securities held in the portfolio. Both interest and capital gains income are passed on to the shareholder. Capital gains may be taxable even if you invest in a tax-free money market fund.
Money market funds may offer you access to your funds through drafts, checks, debit cards, online funds transfer or other methods. Since the net asset value of your shares of a money market fund are typically maintained at a stable rate of $1 per share, you usually have neither a gain or loss on your sale of shares. There is no tax consequence to selling your mutual fund shares as long as the net asset value remains stable. You may have a taxable loss if the net asset value of your money market fund shares decreases below $1, although the Securities and Exchange Commission notes that such occurrences are rare.
Mike Parker is a full-time writer, publisher and independent businessman. His background includes a career as an investments broker with such NYSE member firms as Edward Jones & Company, AG Edwards & Sons and Dean Witter. He helped launch DiscoverCard as one of the company's first merchant sales reps.